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Country and Currency Risk Premia in an Emerging Market

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Author Info

  • Domowitz, Ian
  • Glen, Jack
  • Madhavan, Ananth

Abstract

The magnitude and determinants of country and currency risk premia are of considerable importance to investors and policymakers. Unique data on peso and dollar denominated debt issued by the Mexican government is used to identify and analyze the intertemporal prices of country and currency risk, without resorting to assumptions concerning investor preferences. The results suggest that government authorities in emerging markets can significantly reduce the cost of raising capital, if they can improve international perceptions of the risk of possible currency devaluations and sovereign default. Currency risk is the most important factor, a point especially noteworthy given recent financial crises in Thailand and Malaysia. The premium demanded by investors with respect to currency and country factors shows persistent increases in response to volatility shocks in financial markets. From a policy viewpoint, these findings also suggest that efforts to promote greater stability in domestic security markets can substantially lower government borrowing costs over a long horizon. Our results shed light on the process by which investors' expectations of risk are formed. Rational expectations theories of pricing, as applied to risk premia, are supported for currency risk, while country risk factors appear to be correctly priced only when attention is strongly focused on political events, due to policy shocks, elections, and political assassinations, for example. Policy debates continue over whether or not the 1994 devaluation was anticipted and why the consequences were so severe at market and government levels. Our analysis of the structure of interest rates, country and currency risk premia, expectational errors with respect to the pricing of such premia, and the behavior of country fund discounts all lead us to the conclusion that the develuation was unanticipated. This observation is consistent with capital flows out of the country post-develuation, rather than the usual o

(This abstract was borrowed from another version of this item.)

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Bibliographic Info

Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 33 (1998)
Issue (Month): 02 (June)
Pages: 189-216

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Handle: RePEc:cup:jfinqa:v:33:y:1998:i:02:p:189-216_00

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Cited by:
  1. Sun, Qian & Tong, Wilson H. S., 2000. "The effect of market segmentation on stock prices: The China syndrome," Journal of Banking & Finance, Elsevier, vol. 24(12), pages 1875-1902, December.
  2. Kris James Mitchener & Marc D. Weidenmier, 2009. "Are Hard Pegs Ever Credible in Emerging Markets? Evidence from the Classical Gold Standard," NBER Working Papers 15401, National Bureau of Economic Research, Inc.
  3. Sergio L. Schmukler & Luis Serven, 2002. "Pricing Currency Risk: Facts and Puzzles from Currency Boards," NBER Working Papers 9047, National Bureau of Economic Research, Inc.
  4. Paul Mizen & Serafeim Tsoukas, 2012. "The response of the external finance premium in Asian corporate bond markets to financial characteristics, financial constraints and two financial crises," Working Papers 2012_08, Business School - Economics, University of Glasgow.
  5. Durbin, Erik & Ng, David, 2005. "The sovereign ceiling and emerging market corporate bond spreads," Journal of International Money and Finance, Elsevier, vol. 24(4), pages 631-649, June.
  6. Girard, Eric & Rahman, Hamid & Zaher, Tarek, 2001. "Intertemporal risk-return relationship in the Asian markets around the Asian crisis," Financial Services Review, Elsevier, vol. 10(1-4), pages 249-272.
  7. Girard, Eric & Rahman, Hamid & Zaher, Tarek, 2003. "On market price of risk in Asian capital markets around the Asian flu," International Review of Financial Analysis, Elsevier, vol. 12(3), pages 241-265.
  8. Bergman, U. Michael & Jellingsø, Mads, 2010. "Monetary policy during speculative attacks: Are there adverse medium term effects?," The North American Journal of Economics and Finance, Elsevier, vol. 21(1), pages 5-18, March.
  9. Han, Ki C. & Lee, Suk Hun & Suk, David Y., 2003. "Mexican peso crisis and its spillover effects to emerging market debt," Emerging Markets Review, Elsevier, vol. 4(3), pages 310-326, September.
  10. Martín Grandes, 2007. "The Determinants of Sovereign Bond Spreads: Theory and Facts From Latin America," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 44(130), pages 151-181.
  11. Sokolov, Vladimir, 2010. "Bi-currency versus Single-Currency Targeting: Lessons from the Russian Experience," BOFIT Discussion Papers 7/2010, Bank of Finland, Institute for Economies in Transition.
  12. Paul Mizen & Serafeim Tsoukas, 2008. "Evidence on the External Finance Premium from the US and Emerging Asian Corporate Bond Markets," Working Papers 142008, Hong Kong Institute for Monetary Research.
  13. Lioui, Abraham & Poncet, Patrice, 2003. "International asset allocation: A new perspective," Journal of Banking & Finance, Elsevier, vol. 27(11), pages 2203-2230, November.
  14. Jan, Yin-Ching & Chou, Peter Shyan-Rong & Hung, Mao-Wei, 2000. "Pacific Basin stock markets and international capital asset pricing," Global Finance Journal, Elsevier, vol. 11(1-2), pages 1-16.
  15. Schmukler, Sergio L. & Serven, Luis, 2002. "Pricing currency risk under currency boards," Journal of Development Economics, Elsevier, vol. 69(2), pages 367-391, December.
  16. Özcan Karahan & Olcay Çolak, 2012. "Does Uncovered Interest Rate Parity Hold in Turkey?," International Journal of Economics and Financial Issues, Econjournals, vol. 2(4), pages 386-394.

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